By: Editorial Team, StoneX Media
Asset allocation used to be a real question about how much of a portfolio belonged in bonds and how much belonged in stocks. Low bond yields answered it by default, because a long-dated Treasury paying almost nothing gave investors no reason to hold any of it, and capital went into equities instead. That was not an accident of the market but the intended effect of post-crisis policy, which is why the equity trend since has been relentlessly upward and unusually violent. What matters now is that the mechanism is reversible, and Treasury supply is the thing that reverses it.
James Stanley is a Senior Market Strategist at StoneX Media whose career has moved across asset classes in sequence, beginning with equities in 1999 and adding options, then fixed income in 2006 and foreign exchange in 2009.
Low Treasury yields did not make bonds a bad investment so much as an irrelevant one, and that was the point. When investors fled into bonds during the financial collapse they drove yields down, and as Stanley describes it, that left policymakers with an awkward problem, because "if you're at the Federal Reserve, you have a very real problem that investors don't want to take on risk". Buying bonds and pushing yields lower was the fix, since "if you buy bonds and yields go down, all of a sudden it makes that alternative asset class unattractive as an investment", he adds. The effect was to make a 100% equity allocation look reasonable rather than reckless, which is close to the opposite of how the same investor would have been taught to think about it a decade earlier.
"I think that's one of the reasons that these pullbacks have been bid so aggressively, because there hasn't been a requisite option", Stanley says of the recurring double-digit drawdowns in the S&P 500 since the financial collapse. The trend has been up and to the right, but violently so, with pullbacks arriving often enough to read as a positioning artifact rather than a change of direction. Opportunity cost is the variable that has been absent throughout, and its absence is what made buying weakness the default rather than a judgment call. Consequently the strength of every bid has said as much about the lack of alternatives as about conviction in the assets themselves.
Treasury refunding supply is the mechanism that would put a paid alternative to equities back in front of investors. A large block of long-term U.S. government debt matures over the coming 12 months, and refunding it means issuing new debt into a market already absorbing heavy issuance, much of which covers interest on debt already outstanding. According to Stanley, the pressure shows up from the buyer's seat, with "a Treasury Department that needs to auction off trillions of dollars in debt in the next 12 months, more supply" setting the price and yield arithmetic for anyone holding a bond portfolio. The constraint this removes is a simple one, because "if capital is going to leave stocks, it has to go somewhere", and a long-dated Treasury paying a competitive coupon is somewhere.
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--- Written by Gus Farrow, Senior Manager, StoneX Media
--- Expert: James Stanley, Senior Market Strategist, StoneX Media
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